Editor's Note: In June, IRgA hosted a webinar about preparing your reprographics business for new ownership, and during Joel Salus' presentation on selling to a third party, he discussed the importance of clean financial statements. The article below, reposted with permission from DealStream, explains that when a small business is sold, it can be beneficial to base the sale price on "seller's discretionary earnings" (SED) instead of EBITDA, the common metric.
By Ken Fick
In 1997, Professors Robert Pricer and Alec Johnson published a paper in the Journal of Small Business Management entitled, “The accuracy of valuation methods in predicting the selling price of small firms.” It showed that traditional business valuation models based on SDE and EBITDA often fail to represent real-world transaction values in small-business deals.
Their analysis revealed a large disparity between theoretical values and actual sale prices, as disclosed metrics often ignore critical "soft" variables like owner dependency and buyer motivations that clearly impact transaction value. Financial metrics (e.g., 5x) provide a baseline, but the true value of a small business is dictated by unpredictable market forces.
More recently, in early 2026, a doctoral dissertation at Marshall University ran the same test on 5,499 verified U.S. private business transactions drawn from BVR's DealStats database. The researcher, Joseph Turley, compared how closely SDE-based and EBITDA-based price predictions tracked the actual sale price. SDE-based predictions missed the real price by a median of 33%, and EBITDA-based predictions missed by 74% in his study.
Both SDE and EBITDA-based cash flow valuation estimates produce errors. The question is which one produces fewer of them, and under what circumstances. That depends almost entirely on the size of the deal, the type of buyer in the room, and what the books were designed to accomplish. Get the metric wrong, and you don't just leave money on the table. You can blow the whole deal.
What SDE and EBITDA Actually Measure
SDE and EBITDA serve different purposes and answer distinct questions in business valuation. Knowing which metric to use is key to an accurate valuation.
Seller's Discretionary Earnings (SDE) answers: How much total economic benefit can a single hands-on owner extract from this business? As defined by the International Business Brokers Association, SDE represents the earnings of a business prior to income taxes, non-operating income and expenses, non-recurring items, depreciation and amortization, interest, and one owner's entire compensation, including benefits and personal expenses run through the business.
SDE = Net Income
+ Income Taxes
+ Owner's Full Compensation
+ Interest
+ Depreciation + Amortization
+ Discretionary / Personal Expenses
+ One-Time or Non-Recurring Items
− Non-Operating Income
SDE assumes the buyer will operate the business and fully replace the seller's role. All owner-related benefits, such as salary, vehicle expenses, health insurance, and personal expenditures, are added back because a new owner would receive them.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) answers a different question: What does this business produce in recurring operating profit, independent of how it's financed, taxed, or depreciated? The SEC classifies EBITDA as a non-GAAP financial measure that approximates recurring operating profitability by stripping out interest, taxes, depreciation, and amortization.
EBITDA = Net Income
+ Interest
+ Taxes
+ Depreciation
+ Amortization
In practice, M&A advisors use adjusted (or normalized) EBITDA, which includes adjustments for one-time items and above-market owner compensation. The key distinction is that adjusted EBITDA normalizes owner compensation to market rate, adding back only the excess. For example, if the seller's compensation is $300,000 and a market-rate manager would earn $180,000, only the $120,000 difference is added back. In contrast, SDE adds back the full $300,000.
This distinction is significant. According to the 2025 Pepperdine Private Capital Markets Report, 76% of investment bankers use adjusted EBITDA as their primary valuation method for privately held businesses, while business brokers for smaller deals rely on SDE. As a result, the same business may receive very different valuations depending on the metric used, reflecting the different questions each metric addresses.
Why the Books Lie
The financial reporting of owner-operated businesses is intended to comply with IRS requirements and minimize tax burden, not to reflect economic value. Every legitimate tax-reduction strategy a small business owner deploys, such as family members on the payroll, personal vehicles leased through the company, accelerated depreciation, or year-end expense pull-forwards, creates a financial statement that tells buyers the business earns less than it actually does.
This is not fraud. It is rational behavior, but creates the classic adverse selection problem described by economist George Akerlof in his 1970 paper on the market for lemons. Sellers know what the books conceal. Buyers don't. Buyers who can't separate high-quality businesses from low-quality ones rationally price for the average risk, which means good businesses get discounted along with bad ones.
SDE and EBITDA are meant to address this issue. They function as disclosure frameworks rather than neutral calculations. SDE adds back all owner-specific benefits to reveal total economic value, relying on the buyer to verify these adjustments. EBITDA standardizes financials to reflect the cost of professional management, enabling comparability across businesses.
Both have pluses and minuses. Aggressive SDE add-backs without supporting documentation don't reduce information asymmetry; they amplify it. A buyer who can't verify a $90,000 add-back for 'marketing and entertainment' will discount the entire SDE figure, not just that line. Conversely, EBITDA applied to a deeply owner-dependent business systematically understates transferable value by leaving owner-related economic benefit on the floor.
Turley's dissertation examined this issue directly. He found that as profit margins decrease, SDE becomes more accurate while EBITDA becomes less reliable. Thin-margin businesses often have less formal accounting and greater owner involvement, making SDE's contextual add-backs extremely valuable. This outcome demonstrates underlying information economics.
Same Business - Two Different Numbers
Here is what the divergence looks like in practice. XYZ Plumbing is a fictional $3.2M revenue service business with the following financials:
SDE VS Adjusted EBITDA Calculations
The difference between $696,000 and $556,000 is $140,000. Applying IBBA Q3 2025 median multiples:
- SDE basis: $696,000 × 3.0x = $2,088,000
- Adjusted EBITDA basis: $556,000 × 4.0x = $2,224,000
Using two metrics for the same business results in a $136,000 valuation difference. This gap varies with the extent to which the owner's compensation exceeds the market rate. At $160,000 above market, the difference is manageable; at $600,000 above market, SDE and EBITDA buyers will have fundamentally different perspectives. This difference is significant. Choosing the right metric is essential for positive deal outcomes.
The Four Tiers: Where Each Metric Earns Its Keep
The choice between SDE and EBITDA depends on the buyer pool. Buyers set the valuation convention for their transactions. Sellers who do not conform to the appropriate metric for their market segment may signal a lack of understanding of their counterparties. The data indicates four practical tiers for the SBE market with revenue up to $25 million.
Tier 1 — Under $2.5M Revenue / Under $1M SDE (Main Street)
SDE territory wins, no contest. Pepperdine's 2025 broker survey (Figure 114 &115) shows SDE accounting for 63% of multiple types used on deals under $500K, with the percentage holding into the $1M–$2M range. Buyers here are predominantly individual owner-operators, such as first-time buyers (38%) or serial small-business owners (25%) who intend to replace the seller's role entirely. Turley's data is definitive for this tier: SDE predicts the actual sale price at roughly twice the accuracy of EBITDA across 5,499 transactions.
Tier 2 — $2.5M to $10M Revenue / $1M to $2M EBITDA (Upper Main Street / Transition Zone)
In this range, both metrics are used in parallel, and both can be inaccurate. The SBA 7(a) acquisition loan cap of $5 million excludes individual buyers using SBA financing above that threshold. Below it, these buyers compete with strategic acquirers and private equity add-ons who rely on EBITDA.
Pepperdine's research (Figure 115) shows the shift clearly: individual buyers (first-time and serial operators) account for 50%-63% of deals under $1M in enterprise value, but drop to roughly 40% in the $1M–$2M EV range and 31% in the $2M–$5M range. Strategic and financial buyers (who think in EBITDA terms) are the majority buyers in the $2M–$5M range (69% combined).
The recommended approach in this tier is to calculate both metrics. If the resulting enterprise values differ by more than 15%, review the add-backs for justification. The most common issue is owner compensation. If a seller adds back their full $400,000 salary to SDE while a buyer values the replacement manager at $175,000, this creates a valuation gap that cannot be resolved by adjusting multiples.
Tier 3 — $10M to $25M Revenue / $2M to $5M EBITDA (High SBE or Low-Lower Middle Market)
EBITDA dominates. Approximately 96% of multiples in the $5M–$50M deal range are EBITDA-based. Individual buyers are essentially absent. Strategic acquirers and PE add-on buyers account for almost all transactions. Choosing the appropriate metric is essential. It not only aligns sellers with buyers but also determines whether a deal closes successfully and at what value.
At this level, capital availability becomes uneven. The Pepperdine report indicates a shortage of capital for companies with less than $5 million in EBITDA, but a surplus for those with $10 million or more. Respondents also noted challenges in securing senior debt for businesses below $10 million in EBITDA. The market differentiates between $4.5 million and $10 million EBITDA companies, and valuation metrics should reflect this distinction.
GF Data's H1 2025 small-deal report confirms a multiple gap in private equity-sponsored deals. Transactions with enterprise values between $1 million and $10 million traded at approximately 5.5 times trailing EBITDA, while those between $10 million and $25 million achieved multiples of 6.2 to 6.7. This reflects a structural pricing tier.
Tier 4 — $25M Revenue+ / $5M EBITDA+ (Lower Middle Market)
This tier is dominated by private equity platform deals, where adjusted EBITDA is the standard metric. The size premium is well documented, and deals above $5 million in EBITDA exhibit fundamentally different valuation dynamics than smaller transactions. Pepperdine's 2025 investment banker survey (Table 27) shows the progression with precision:
The most significant increase in multiples, from 4.0x to 6.1x (a 50% uplift), occurs when moving above $1 million in EBITDA. The next major step is at $10 million in EBITDA, where capital becomes more accessible and private equity platform buyers show increased interest.
The $10M EBITDA Inflection
The $10M EBITDA threshold is not arbitrary. Below it, the 2025 Pepperdine report describes PE valuations at 5.5x for $10MM EBITDA companies, the entry-level price of admission to institutional buyer interest. Above it, multiple accretions are consistent and traceable. This has two practical implications that matter to SBE owners and advisors:
- First, a business with $9.8 million in EBITDA is not valued the same as one with $10.2 million. The multiple increased from approximately 6.6x to 7.2x, resulting in a multi-million-dollar difference in enterprise value despite similar operating performance. The price gap is driven by the buyer pool, not earnings. Therefore, sellers in the $8 million to $12 million EBITDA range often spend 12 to 18 months optimizing earnings before going to market, as crossing this threshold has a significant financial impact.
- Second, buyers considering a $5 million EBITDA business priced at 8x EBITDA should question the basis for this multiple. Such pricing assumes institutional private equity interest, which is often not present at this level. Pepperdine data indicates that 6.6x is the typical market-clearing multiple for this EBITDA tier. The difference between 6.6x and 8x on $5 million in EBITDA is $7 million, representing a significant valuation gap.
Practical Takeaways
For Sellers
- Thoroughly document every add-back in your SDE schedule. Each discretionary adjustment should be supported by receipts, contracts, or W-2s that a buyer's Quality of Earnings reviewer can independently verify. Unsupported add-backs may lead buyers to assume additional undisclosed items, resulting in a discounted offer. A well-documented SDE schedule signals transparency and can reduce a buyer's discount.
- Select the valuation metric that fits with your buyer pool, rather than the one that yields the highest headline figure. For Tier 1 or 2 deals, use SDE. For Tier 3 or 4, where buyers are institutional, using SDE may indicate a lack of understanding of market expectations.
- If your business is nearing the $10 million EBITDA threshold, carefully consider timing. Surpassing this level increases value not only through higher earnings but also by qualifying for a higher multiple due to a broader pool of buyers.
For Buyers
- Each SDE add-back should be verified. The key consideration is whether the underlying expense will recur under new ownership. For example, an owner's vehicle expense may be legitimate and transferable, while $85,000 in consulting fees paid to the seller's spouse requires documentation and a clear rationale for discontinuation.
- In the $2.5 million to $10 million revenue range, evaluate both metrics. Calculate enterprise value using SDE and the appropriate multiple, and again using adjusted EBITDA and its multiple. If the results differ by more than 15%, investigate specific add-backs or owner compensation normalization before closing the transaction.
- If a deal in the $2 million to $5 million EBITDA range is priced above 7x, determine whether the seller has access to a unique buyer pool or if an inappropriate multiple is being applied. Clarify who else is bidding and what they are willing to pay.
For Brokers and Advisors
- Turley's findings on profit margin provide practical guidance: SDE is most effective for businesses with informal financial records. Thin-margin, owner-dependent, or tax-optimized companies benefit from SDE's contextual add-backs, which capture value that EBITDA may overlook. Using EBITDA for these businesses does not improve price accuracy.
- Standardize add-back documentation for every engagement. Inconsistent SDE presentation contributes to its weaker credibility in academic research and buyer due diligence. Brokers who provide clear, well-supported adjustment schedules differentiate themselves and help reduce buyer uncertainty, directly benefiting their clients.
- Set client expectations according to the size-premium curve. IBBA Market Pulse data show that $5 million to $50 million enterprise-value transactions average 6.0x EBITDA, with a range of 6.1x to 7.2x, depending on EBITDA size. Sellers with $2 million EBITDA businesses should understand multiples may likely be lower before receiving a letter of intent.
SDE And EBITDA As Tools
SDE and EBITDA are tools for quantifying private business performance for negotiation purposes. Neither metric fully represents the business itself. Both are approximate and can be highly inaccurate if applied without careful consideration of the informational context.
The data clearly indicates when each metric is appropriate. The transition between metrics is determined by the buyer’s profile, their approach to replacing the owner in the management role, and capital market preferences. Using the wrong metric for your tier can lead to miscommunication with potential buyers. That is a problem no multiple can fix.
About the Author
Ken Fick is a CPA and MBA with over 25 years of finance experience providing leading-edge solutions designed to improve forecasting, budgeting, planning, and decision-making to companies from $3 million to over $50 billion in revenue. He is a freelance writer that focuses on producing engaging content on all things business, accounting, finance and investment related. You can view a sampling of his published work at FPAexperts.com.
DealStream, its authors and affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.